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Interest Rates | Life After Libor

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Libor, the London interbank offered rate at the center of a massive rate-rigging scandal that came to light in 2012, is still being used as the benchmark for $350 trillion of financial contracts around the world. However, Britain’s Financial Conduct Authority (FCA) has pledged to phase out Libor by 2021. Regulators in Britain and elsewhere will begin replacing it, as early as next year, with new transaction-based reference rates.

The Bank of England announced in October that it would move to a new version of Sonia, the Sterling Overnight Index Average, on April 23, 2018. The reformed benchmark will track actual overnight funding deals in the wholesale money markets, instead of relying on submissions from a panel of banks.

Meanwhile, the Swiss National Bank said its working group on reference rates has recommended Saron, a benchmark for the overnight repurchase (repo) market, as the alternative to the Swiss franc Libor.

When it was published under the auspices of the British Bankers’ Association, Libor reported the cost of borrowing in British pounds, dollars, euros, Japanese yen and Swiss francs for various maturities up to one year. Libor has since been reformed to focus on real market data and will continue to be published by the Intercontinental Exchange.

In the US, the Federal Reserve requested comment through October 30 on a proposal for the New York Fed to produce three new reference rates on overnight repo transactions. The most comprehensive of the three would be the Secured Overnight Financing Rate (SOFR), a broad measure of overnight US Treasury security transactions, which could serve as the alternative to US dollar Libor.

“We are still in the early stages, and the future of Libor after 2021 is uncertain,” Steven Zeng, US rates strategist at Deutsche Bank, said in a recent conference call. “There will have to be a buildup of liquidity in SOFR, which will take a lot of work,” he added. “We will need protocols similar to the switch to the euro” when the single currency was first introduced.

Fed governor Jerome Powell said in a release: “SOFR will be derived from the deepest, most resilient funding market in the US. As such, it represents a robust rate that will support US financial stability.” It will be based on data from BNY Mellon and the Depository Trust & Clearing Corporation.

The European Central Bank is considering using a weighted average of all overnight unsecured interbank lending, and the Bank of Japan has selected the uncollateralized overnight call rate known as Tonar.

Liquidity in the market for unsecured wholesale term lending between banks has dried up since the global financial crisis. Therefore, there are not enough transactions to provide accurate data for setting Libor, according to Andrew Bailey, chief executive of the UK Financial Conduct Authority. The proposed alternative benchmarks will be broadened to include a larger number of transactions, so they will more accurately reflect true market conditions and cannot be easily manipulated.

These benchmarks act as “risk free” market rates on which banks base their pricing for products ranging from corporate debt and home mortgages to student debt. They are critical to the smooth functioning of the credit markets.